Who would be the winners and losers from Brexit? Rory Bateman’s quarterly look at European equity markets includes analysis of the implications of the UK’s EU referendum.

22/04/2016

Rory Bateman

Head of UK & European Equities

During our last quarterly review we highlighted the increased market volatility driven by an array of global and European issues.

Many of these issues remain but sentiment has undoubtedly improved since mid-February. Our prognosis that the weak markets were a function of negative sentiment rather than a significant deterioration in the economic fundamentals appears correct in the short term.

For the purposes of this review we will primarily focus on the UK’s EU referendum which many commentators view as the most important issue for UK and European investors to consider this year.

The other potential risks to markets discussed previously - such as the European recovery, corporate earnings growth, Chinese hard or soft landing, US interest rates etc - remain valid but there’s not much more to be said for now.

After a brief first quarter summary of the markets, we’ll move straight into the EU discussion.

Q1 summary: ECB action, Italy under pressure, growth outperforms

Pan-European equities finished the first quarter down 8% having rallied by 10% from the mid-February lows.

Much of the fear experienced in the first six weeks of 2016 - driven by global macroeconomic concerns - dissipated as Chinese data stabilised and the US Federal Reserve adopted a more dovish tone on interest rate increases.

More recently, the European Central Bank (ECB) expanded its quantitative easing programme and reduced the deposit rate to -0.4%.

Equity markets have responded quite well to the additional policy measures although ECB president Mario Draghi’s comments about the limited benefits of further loosening have lead to euro appreciation.

The Dutch market was the best performing major exchange during the quarter, delivering flat returns, with Italy the main laggard, falling 15%. The Italian market suffered because of worries over the burden of non-performing loans in the banking sector.

Financials make up over a third of the index and so when they perform poorly the Italian market is dragged down further than other EU markets.

The first formal merger of two popolari (co-operative) banks also took place. These mergers are part of the government’s plan to strengthen the banking sector.

However, markets were surprised by the regulator’s insistence that the merger be accompanied by a rights issue, which added further uncertainty to an already uncertain situation.

Growth versus value

Stylistically we saw a continuation of the growth versus value1 trade - Chart 1 below shows growth has now outperformed value for the longest period on record.

Having said that, most of the value underperformance in the first quarter came from the European banks.

The negative interest rate environment has exerted significant pressure on net interest income and it has been an extremely tough period for the investment banks.

Other value sectors such as energy and commodity plays performed well given the recovery in oil and metals prices.

We have argued that the ongoing supply response will eventually lead to some recovery in oil, but we have less conviction around a sustainable bounce in metals prices given that supply in many areas continues to come on-stream.

Overall, as we have said previously, many of the opportunities we are seeing reside within the value category and this continues to be the case.

The fall in the market so far this year is at least partially justified given modestly declining earnings revisions. Chart 2 shows earnings growth forecasts which have fallen from +6% to approximately flat for 2016.

There’s little doubt the global growth concerns combined with increasing fears around a ‘Brexit’ have damaged confidence and possibly caused a delay in corporate investment decisions.

The UK referendum on UK membership

Referendum day has been announced, the gloves are off and the debate is seriously gaining momentum.

Our previous concerns look well founded, i.e. that political shenanigans would overshadow the really important issues such as the probable impact on British businesses in the event we choose to leave the EU.

In order to understand the key aspects of the debate we have carried out our own proprietary research by talking to companies about how staying or leaving the EU would impact their companies, their industries and the overall UK economy.

In addition we have had a number of internal discussions with high profile politicians, economists and current MPs.

There will be many non-economic factors influencing voters such as sovereignty and immigration. On these matters we express no opinion since, like everyone else, opinions across the team differ.

Instead, we would like to provide our survey results followed by some general thoughts around the possible market reaction as well as some sector-specific analysis.

Our overall perception of the business surveys that have been carried out in recent weeks is that UK companies are more in favour of staying in rather than leaving the EU.

Our surveys would support this perception with approximately 60% of large UK companies suggesting they felt their businesses are better off remaining within the EU.

It is worth pointing out that the response to our survey was limited with only 35 larger companies responding, of which only 22 were prepared to express a view.

A bespoke survey of 500 smaller companies (turnover >£50,000) is perhaps more illustrative of UK corporates who - when asked about their company, sector or the UK economy - were consistent in saying, two to one on each question, that the impact of leaving the EU would be negative.

In isolation these surveys would indicate that a vote to leave the EU may be negative for UK companies.

However, this generic response doesn’t tell us how the markets may react or indeed which sectors could be most impacted. In the remainder of this review we will attempt to address these questions.

How likely is Brexit?

Opinion polls have tightened considerably post Prime Minister David Cameron’s EU deal announcement with the average of the last ten polls (whatUKthinks.org) showing that ‘remain’ is ever so slightly ahead but pretty much 50/50.

Remain had a lead of 7% last Christmas, falling to <1% today, but we also need to consider the c.15% of the population that are undecided who may be more inclined to vote conservatively, favouring the existing arrangements.

This would appear to have been the case in the Scottish referendum and the UK general election.

The other, possibly better, way to judge the likelihood of Brexit is to see what the bookies are saying.

Chart 3 below shows Betfair exchange has a two-thirds implied probability of remain. It is also worth bearing in mind that the polls (and the bookies to a lesser extent) were poor predictively on the Scottish referendum and general election.

Basically, it’s very hard to call despite the current remain lead and certain events (terrorism, refugee crisis, etc) could swing things considerably over the next 10 weeks.

Chart 3: Betting markets show lower Brexit risk than opinion polls

Source: Betfair.com, Schroders, 30 March 2016.

What would be the impact of a leave vote on the UK stockmarket?

We believe there are three key implications from Brexit, namely weak sterling (this would have an inflationary impact over the medium term); increased uncertainty (regulatory, political and markets); and short-term economic weakness.

On these uncertainties, the headlines would focus on political uncertainty around Scotland and David Cameron if we leave, while the financial pages would debate the sustainability of London’s status as a financial centre.

One other factor to consider would be the impact on bond yields and the equity risk premium2 but it’s not clear whether gilts will be seen as a safe haven or as a victim of capital flight.

A key point to make is that the UK stockmarket is very different from the UK economy, with the FTSE 100 basically a global stockmarket listed in London.

More broadly, a leave vote may have a negative impact on other European bourses as investors may fear that similar votes may follow elsewhere and challenge the sustainability of the euro.

Which sectors are likely to be affected?

We believe broadly speaking that Brexit would weigh on domestic cyclicals3, mainly consumer cyclicals and financials. Indeed, we know of two investment banks who have established baskets of stocks which they believe will suffer from Brexit.

They are both heavily weighted to the banking, real estate and retail sectors and so act as something of a proxy for current investor sentiment.

Sterling weakness benefits the overseas earners translating their profits back to sterling, and is even more of a benefit for those companies with significant overseas earnings and also with a large UK cost base since a transaction benefit would boost competitiveness.

The FTSE 100 is much better placed than the FTSE 250 in terms of overseas earnings and cyclicality (the FTSE 100 only has around 21% UK revenue and has 40% of the index in defensive sectors, compared to more than 50% UK revenue and 12% in defensives for the FTSE 250. The small-cap index, for its part, has more than 60% revenue from UK).

We have asked our analysts for some insights into their sectors.

Likely sector losers?

General retailers: In some cases as much as 60% of retailer sourcing is in US dollars, with their entire revenue base here in the UK which means sterling weakness will have a significant impact on their profitability. In addition any economic slowdown will affect general spending, particularly discretionary purchases.

Airlines: A highly cyclical industry with a significant chunk (>35%) of their cost base in US dollars but with limited dollar revenue which suggests the currency fluctuations will have an effect on profitability. The regulatory picture may change if the UK leaves the EU given the single aviation market structure is up for debate, but from a volume of traffic perspective, lower immigration may have an effect.

London commercial real estate: London’s ability to retain its status as Europe’s pre-eminent financial centre is unclear but we have already seen a de-rating of the sector brought about by possible lower rents and funding issues.

Housebuilders: Homebuilder companies, particularly those exposed to the London property market, are at risk especially given the extended rally in these stocks over recent years. These are highly cyclical stocks with very high operational gearing. Modest declines in house prices have a significant impact on earnings with a 1% price fall impacting earnings per share by around 5%.

Domestic banks: Banks are economically cyclical and vulnerable to negative sentiment. The uncertainty introduced by a possible re-run of the Scottish referendum would be negative for Lloyds and Royal Bank of Scotland with higher wholesale funding costs, at least in the short-term. However, it’s worth noting that valuations are very low and they will almost certainly have priced something in already for Brexit risk. The lack of clarity around the ability of multinational banks operating in London (US, Swiss, European) to passport financial services from the UK into the EU could also result in a downsizing of the broader UK financial services hub.

Likely sector winners?

Consumer staples, pharmaceuticals, capital goods, resources and software are all big overseas earners who may benefit from the improvement in competitiveness driven by a weaker sterling for those who manufacture in the UK.

Food retail could be an unlikely winner (depending upon the severity of short-term economic weakness) basically as sterling weakness would be inflationary. The sector tends to pass on all inflation (these are largely non-discretionary purchases and so sector pricing tends to move as one with inflation) and there is a strong correlation between sector valuations and inflation. The deflationary environment has been difficult for the sector recently, resulting in lower valuations across the sector. This could turn into a mild tailwind.

The UK technology sector in general is a big overseas earner, and therefore would benefit in the short term from any sterling weakness resulting from Brexit. In both software and hardware, the vast majority of companies have a significant percentage (+75%) of revenue coming from overseas. However, there is a potentially negative impact from Brexit in the longer term. A large number of tech firms rely on an often international workforce; should a post-Brexit world make it harder for tech firms to attract and retain these talented individuals, this would likely have implications in the long term for firms’ ability to maintain their competitive advantage of leading edge intellectual property and innovation.

Conclusion: take advantage of market volatility

The degree of uncertainty around what will happen in the event of the UK leaving the EU is significant.

It’s impossible to say how long trade re-negotiations will take or indeed whether the eventual arrangements established will be positive or negative for the UK economy over the medium to long term.

It’s probable that volatility will pick up in the run up to and post the referendum, whatever the outcome.

The direction of the UK and European markets will be driven by the result itself and the policy response of governments and central banks, while the reaction of individual stocks and sectors will depend to a large extent on what the market is pricing in immediately prior to the referendum.

We have attempted to take a pragmatic approach in understanding the implications for markets and sectors but our clients should be very aware that we will opportunistic and ruthless in exploiting the market inefficiencies that may arise through this volatile period.

The analysis and evidence presented is intended to inform investors and not to persuade voters or influence the outcome of the upcoming referendum.

1. Growth stocks are those with high rates of growth, both current and projected forward, while value stocks are those that have ben under-priced by the market and have the potential to rise in value.↩

2. A risk premium is the extra return that an investor expects to earn as compensation for owning an investment that is not risk free.↩

3. Cyclical stocks are those with greatest sensitivity to the economic cycle while defensive stocks are less dependent on the economy.↩

The UK’s vote to leave the EU has resulted in a significant pullback in markets but investors should not over react to today’s volatility. Non-domestically focused equities may prove the best way to navigate the market uncertainty.

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